One cheap oil stock to buy now

As oil gets scarcer, it becomes more difficult to extract. And so the companies making the complex tools to reach it should prosper. Chris Mayer tips one company that's going cheap, and has a bright future ahead of it.

Tesco Corp. (Nasdaq: TESO) looks like a very cheap stock to me. This oilfield services company is not merely cheap in relation to its long-term growth prospects, but it is also VERY cheap in relation to recent takeover prices in the sector.

Last summer, Cameron Intl. announced it would acquire Natco Group for $780 million, or about nine times trailing EBITDA. (EBITDA stands for earnings before interest, taxes, depreciation and amortization. It's a good rough measure of earnings power to use when comparing firms across a sector.)

It's been a while since we've seen some headline-grabbing acquisitions in this space. It's about time. Last summer, Precision Drilling bought Grey Wolf, a clunky land driller with old rigs, for 5.1 times EBITDA. And before that, we had a spate of deals north of ten times EBITDA, including Hydril's purchase of Tenaris.

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In the same view, we can buy Tesco a quality oil field services company known for its cutting-edge technology for under three times EBITDA. If Natco went for nine times EBITDA, this one ought to go for no less. And that would mean a gain of 226% from here. Even without the acquisition, though, there is lot to like. Let's talk technology for a minute to understand just what Tesco does so well.

Tesco designs, makes, sells, rents and services top drives. A top drive is a motor that sits on top of rig and spins the drill. I don't want to get too geeked up in the technical aspects of this if you're interested, there is plenty of detailed information on the company's website . The key thing to know is that top drives power the directional and horizontal drilling rigs that access unconventional natural gas reserves all those shale plays. As more and more supply comes from shale plays, unconventional wells will grow much faster than conventional ones. Hence, a nice backdrop of demand for Tesco's top drives.

This is a big market with an installed base of over 3,000 top drives around the world. As time goes by, more and more rigs will have top drives, which provide some growth opportunities even if the total number of rigs stays flat. In particular, there is more opportunity in the land rigs than offshore.

Most of these existing top drives are from National Oilwell Varco. Tesco is No. 2. And Canrig, a division of Nabors, is No. 3. Tesco also rents top drives. In this business, it is top dog, with a rental fleet of about 126 top drives.

As for casing services, Tesco has a proprietary service that allows a driller to drill and case a well simultaneously. Casing a well means putting steel pipe down the well bore so the thing doesn't collapse on itself. The ability to drill and case at the same time cuts in half the number of days needed to complete a well. It's a big timesaver, and many expect the industry to adopt Tesco's technology, which would be a big boon to Tesco.

This casing technology really makes Tesco stand out from the pack. There is no other company with Tesco's technology. Tesco thinks that the market for this technology is in the billions. Currently, it's only about $50 million and growing. We've got a long runway here, though I think someone will buyout Tesco before too long.

I want to emphasise that these products are highly engineered and complex. Tesco owns a portfolio of over 80 patents and is developing another 120 patents to protect its proprietary applications. This is why I think of Tesco practically as a tech stock. And it's why Tesco deserves a premium valuation and remains a great acquisition for somebody. A much larger company, like a National Oilwell Varco, could take this know-how and apply it more widely over a larger customer base and push these products through its bigger distribution network.

About half of Tesco's business is from outside the US, which is holding up better than the US market in this mess. This recession also plays well to Tesco's strengths, because its tools cut the time needed to drill and complete a well, and help its customers make more money.

Also, Tesco's customers are mostly large firms BP, EnCana, Petrobras, Occidental and the like. They are not the little guys who are going belly up. Tesco's customers are likely to remain active even in a relatively low-price environment.


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As far as the financials go, there is not a lot to worry about here. The company has a strong balance sheet. Cash was $20.4 million at the end of the second quarter and debt was only $44 million. Tesco produces good cash flow and has low capital spending requirements and most of that is discretionary. Management intends to finish the year with zero debt. So we have a company able to build cash even in this tough environment.

There are 38 million shares outstanding, and the stock trades for $8.50 as I write. That's a market cap of $319 million. Add in the net debt of $24.6 million and you can have the whole company for $345 million today (enterprise value, or EV). This year, the company will generate EBITDA of about $75100 million. (Last year, EBITDA was $109 million). On a trailing EBITDA basis, Tesco trades for about 3.2 times EBITDA. Comparable companies would include Weatherford, Cameron, National Oilwell Varco and Natco, among others. As I pointed out earlier, Cameron bought Natco for nine times trailing EBITDA. That kind of multiple gets you a $25 stock price for Tesco.

But you don't need the acquisition to make money when you buy at four times EBITDA or better. Cameron, for example, trades for six times EBITDA today. Even just getting back to a more normal historical multiple would put Tesco's stock closer to $15. It's just very cheap, especially when you consider the bright future ahead of it. It wasn't that long ago when people were talking about Tesco as a $40 stock.

This is not the retail sector, in which we have to figure out whether or not Tesco's next hot bluejeans are going to sell or whether customers will like the new store formats. We're talking about stuff you need to produce the oil and gas that keeps civilisation a going concern. We're talking about highly engineered products that save customers a lot of dough. We're talking about a company that benefits from one of the great stories of our time: going ever deeper to reach untapped reservoirs of hydrocarbons once thought inaccessible. It's a heroic effort and the companies that can do it are going to make a lot of money and so are their shareholders.

An added bonus: The executives and directors own 18% of the stock. So they have every incentive to maximise the value here. I'm betting they will.

This article was written by Chris Mayer for the daily investment email The Daily Reckoning and was first published on 3 November 2009